Oil shocks and their impact on fixed-income markets

What can the Arab oil embargo, Iran crisis and First Gulf War tell us about the impact of oil shocks on fixed income? We analyse these episodes and provide three scenarios for the current situation, assessing total return implications given the potential rate and spread moves. This report is the fifth and penultimate part of our latest quarterly assessment of global fixed-income markets, Alphorum. In our previous reports in this series, we focused on what fixed-income scenarios could result from the current market shock, what the central bank’s war on inflation means for developed-world bond markets and the new duality within the sovereign Emerging Market universe as well as credit opportunities in these volatile times. In the last part of our series coming up next, we will explore the dynamics driving sustainable fixed income.

 

Need to know Analysing the impact of past oil shocks can help understand the likely consequences for fixed-income markets from the war in Ukraine. We have studied the 1973-1974 Arab oil embargo, the 1979-1980 Iran crisis and the First Gulf War. Unlike with banking crises, a commodity shock alone will not normally lead to a solvency crisis. In terms of rates, central banks are inclined to look through supply-side shocks given that their toolkits have little impact. When confronting uncertainty, scenario analysis can help anchor and rationalise investment decisions. We have therefore calculated the total return implications given a range of rate and spread moves into year end.

 

Shock of the new

In the wake of the Russian invasion of Ukraine, energy prices have become a focal point for markets, with oil the prevailing bellwether. The move by western nations to ban imports of Russian oil saw prices spike acutely, leading markets to question the capacity of corporates and sovereigns to absorb the associated rise in input prices.

In this analysis, we assess the impacts on rates and credit markets of previous oil shocks, focusing on the periods around three past events: the Yom Kippur war and Arab embargo of 1973-74; the Iran hostage crisis of 1979-80; and the First Gulf War of 1990. This is followed by a scenario analysis to quantify the potential effects of the current situation in the fixed income space on total returns.

 

How comparable are past episodes to the current situation?

Before diving into our analysis of past oil shocks, it’s worth considering how comparable prior episodes are to the current scenario. In terms of price, at the time of writing oil has seen more than 50% upside compared to pre-conflict levels. As you can see from Figure 1A, this is actually substantially smaller than the moves seen during the Arab oil embargo and First Gulf war, which saw prices rise to 3.5 times and 2.5 times their prior levels respectively, but is similar to the increase seen at this stage in the Iran crisis.

However, price rises do not tell the whole story; a key consideration when comparing market fallout from the current crisis to previous episodes is oil’s ongoing impact on GDP. As illustrated in Figure 1B by the fall in oil intensity of US GDP over time, oil’s importance in the global economy is substantially lower now than it has been historically. This would indicate that the greater importance of oil to global economic activity during past episodes emphasised the scale of the shock, causing them to be more damaging for global growth and potentially less relevant as proxies for the current situation.

 

FIG 1A. Oil prices through prior price spike episodes (rebased to 100)

FIG 1B. Oil intensity of US GDP over time

Source: Bloomberg, Barclays, LOIM calculations. As of March 22, 2022.

Source: Christoph Rühl and Titus Erker, Center on Global Energy Policy at Columbia University.

 

Having said this, the fall in relevance for oil in GDP has to some extent been replaced by the rising relevance of alternative energy sources such as natural gas. Gas has far more linkages to the global economy now than historically, and has experienced a larger price increase than oil during the latest episode.¹ Prior conflict-related shocks are therefore more relevant to the current scenario than assessing the oil market alone would suggest. In fact, the European economy’s dependence on Russian gas is reminiscent of the US economy’s reliance on external oil sources throughout the previous episodes we are analysing here.² Consequently, a study of prior oil shocks is extremely useful in helping to understand what we can expect as a result of the current situation. 

 

Impact on credit spreads and defaults

As you can see from Figure 2A, the moves in credit spreads since the start of the conflict have been substantial, and sharper than in any of the prior episodes. US investment-grade credit spreads roughly doubled in 1973-74 and in 1979-80, while they moved 50% higher in 1990. However, it is interesting to observe that default rates in the first two periods were benign (see Figure 2B). Although default rates were higher during the First Gulf War, this was linked to the savings and loans crisis, as well as the freezing of the junk-bond market on the back of a boom in leveraged buyouts. Importantly, defaults had little to do with commodities.

 

FIG 2A. Moves in investment grade credit spreads (rebased to 100)

FIG 2B. 12-month trailing speculative grade default rates and forecasts

Source: Bloomberg, Barclays, LOIM calculations. As of March 22, 2022.

Source: Moody’s. As of February 28, 2022.

 

The key inference is that unlike banking crises, which are a much more potent threat to corporate liquidity, commodity shocks alone do not necessarily lead to a solvency crisis. Further evidence for this can be found by comparing the performance of US credit and US equities in the wake of the 1973 oil crisis and during the global financial crisis of 2008 (see figures 3A and 3B). As you can see, the 1973-74 shock was much worse for equity returns than it was for credit. In contrast, during the global financial crisis equities experienced a similarly sized drawdown, but the credit shock was much worse after 12 months, at roughly 2-2.5 times the size. This supports our belief that, in the absence of a banking crisis, a commodity shock can be damaging for earnings but not solvency, so that initial credit drawdowns would be followed by a recovery.

 

FIG 3A. US Credit return index during the 1973-4 oil shock and the GFC

FIG 3B. US Equities return index during the 1973-4 oil shock and the GFC

Source: Bloomberg, LOIM calculations as at March 2022

 

Impact on rates

Unlike spreads, rate changes following oil-price shocks have varied (see figure 4). The Iran Crisis and Gulf War periods saw rates fall initially at the short end, with a slight steepening bias. In contrast, during the Arab oil embargo of the early 1970s, short-end rates rose, with a slight flattening bias.

Ultimately, drawing comparisons between rate movements during oil shocks is more challenging than for spreads, with the starting point of central banks more important than the shock itself. As supply-side shocks, central banks tend to look through oil-price spikes, since their toolkits have little-to-no impact in such a situation. The First Gulf War episode clearly demonstrates this, with the oil shock failing to derail the Fed from its pursuit of lower rates. The much lower starting level of rates in the current episode (1% compared with 7-9% in the 1970s and 1990s episodes) and the substantially lower neutral real rate underline the very different central bank positioning this time around. Given these conditions, we expect central bank mandates will continue to drive medium-term rate performance, with the Russia-Ukraine conflict having little impact.

FIG 4A. Move in short US Treasury rates during oil shocks

FIG 4B. Move in long US Treasury rates during oil shocks

Source: Bloomberg, LOIM calculations. As of March 22, 2022. 

 

Scenario analysis

At times of market drawdown, it is easy to lose sight of the potential future drivers of total returns. Indeed, a key element of increased yields and spreads this year is an accompanying increase in carry on offer as we move through the rest of the year. Amid uncertainty, scenario analyses can provide a much-needed forward-looking anchor to rationalise investment decisions.

Our analysis below focuses on the total-return implications given a range of rate and spread moves into year end. We have focused on global crossover – bonds on the dividing line between investment-grade and high-yield – with a rating between BBB and BB. This particular fixed-income segment was chosen because it displays the most consistent balance between duration and spread risk.³ Figure 5A shows the forecasted 12-month forward returns as of 15 March, 2022, based on a range of moves in US and German rates, as well as US and EUR investment-grade and high-yield spread moves. We present a broad range of outcomes here to allow for selection of any combination of rate and credit moves.

In figure 6, we set out three potential economic scenarios. The central scenario would see a 3-3.5% absolute return in EUR hedged terms; this is actually slightly above the optimistic scenario, in which further increases in rates would consume the positive mark-to-market return from tighter spreads. However, and most interestingly, even the pessimistic economic scenario would result in positive returns, as we foresee a downturn in economic activity being met by a fall in rates, which, alongside higher carry, would offset a sizable widening in spreads. This provides us with comfort that in the event of an economic downturn driven by the Russia-Ukraine conflict, the duration and carry buffers built up from the credit/rates sell-off would be sufficient to provide ample support to diversified fixed-income strategies.

 

FIG 5A. Scenario analysis on global crossover segment to assess total returns over the next 12 months

Source: LOIM. As of March 2022. For illustrative purposes only, results are simulated and may not reflect the reality

 

FIG 5B. Central, pessimistic and optimistic geopolitical scenarios and their macro and policy implications

	Central	Pessimistic	Optimistic
Geopolitical backdrop	Russia-Ukraine conflict continues but remains local with no further major economic disruptions on a global scale. High volatility persists as diplomatic efforts will be slow.	Serious escalation of the conflict from both sides. Sanctions on energy. Military escalation. No diplomatic progress. Recession risk increases.	Some de-escalation, but some lasting damage is done. Situation remains tense but tail-risks decrease. Pragmatism and diplomatic progress returns.
Macro and policy implications	Stagflationary impulse; commodity prices feed into inflation, while growth slows down in the medium term. Policymakers implement fiscal push, with monetary policy expected to be dovish on the margins as they look through the supply shock.	More entrenched risk-off situation with repercussions and some broader contagion across asset classes, countries and sectors. Monetary policy on hold in Europe as risk from growth downside dominates. Sizeable fiscal response.	Base effects quickly reverse high inflation readings and monetary policy can focus on the underlying state of the economy. Original tightening schedule is put back in place. Growth downside is limited.

Source: LOIM. As of March 2022. For illustrative purposes only

 

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